The Brown Paper Bag Challenge

The Debate Over the Frequency of Disclosure to Structured Finance Investors

There is adebate over how frequently investors and other market participants should be given updated loan-level performance data. Some sell-side dominated lobbying firms, issuers and individuals prefer once-per-month or less frequent disclosure.

At TYI, the strong preference is to link the timing of reporting to investors to the occurrence of an observable event involving the underlying loan collateral on the day the event occurs. The list of observable events which would trigger an event-based report includes payments and the amount of the payments, failure to make a payment, amendments or modifications to the collateral or the start of bankruptcy proceedings.

Is Observable Event-based or Once-per-Month Disclosure Better for Restarting the Securitization Market?

To answer this question, we need your help. We have here a brown paper bag with a question mark on it that represents the lowest risk piece of a structured finance security.Each of you is a potential buyer of this security.

At the beginning of last month, when we put this security together, it had $100 of collateral in it and we had an offer to buy it at $100.In the interest of full disclosure and because we don’t have time, nor do we want to pay the expense, to circulate a prospectus with its convoluted legal text for you to read, let us summarize the key risk factor.The key risk is that you don’t know how the collateral has performed since then.

Now, would you be willing to buy it from us today for $95? We have never had any takers at that price.The fact that no one would buy the security tells us three things.

·First, it tells us that with no current data about the performance of the security’s collateral, there is no market for the security.

·Second, it tells us that you learned that careful attention must be paid to the representations and warranties made about the assets backing a security.For many of you, this lesson sank in as you began to re-read some of the prospectuses for sub-prime mortgage deals and discovered that Issuers were allowed to load up the security with the worst assets from their balance sheet.

·Third, it tells us that what someone else was willing to pay or paid for a security does not tell you what the current value of the security is.

Since you would like to know what is inside the bag, let me share with you last month’s remittance report.The reason for showing you this remittance report is that this is the data currently available to market participants and preferred by some analysts when they want to see what is going on with the collateral backing any structured finance security.According to the end of month remittance report which was just released, the cash paid out during the previous 30 days was $25 and the estimated value of the remaining collateral was $75.

We must remind everyone that today is not the last day of last month. A simple model for valuing the security would be $75 minus the value of $25 multiplied by today's date and divided by the number of days in the month. This model assumes that the performance of the collateral is the same this month as it was last month.

Since the end of last month while we have continued to collect information on the collateral as observable events involving the collateral have occurred, there has been no information made public on the performance of the collateral.

Would you buy the security from us today for $70? We have never had any takers at that price either. How about $50? Sometimes we have a buyer here.How about $10? All the traders show up at this distressed price.

The fact that virtually no one would buy the security at a higher price tells us that we still have not provided you with the data you want to value the security and therefore there is still no market or at best a distressed market for the security.This also confirms the results of a December 2008 McKinsey & Co. survey done for the global industry trade groups (SIFMA, ASF, ESF and AuSF).

In this survey of global market participants in the securitization market, disclosure of information on underlying assets is listed as the most critical to restarting the market. Like these market participants, you would like to know what is in the bag this instant because it could be substantially different than what an out of date, end of month, remittance report shows.

Since you would like to know what is inside the bag this instant, let us show you what we believe the future of structured finance will look like with loan-level data being provided on an observable event-based basis. It would come to resemble looking through a plastic bag.

If you could see that the plastic bag has $50 in it, you would probably be willing to buy the contents of the plastic bag for $45. We suspect that almost everyone would be happy to buy the contents of the plastic bag for $45 and make a $5 profit if they can verify that the plastic bag contains a real $50 bill.

Why have we been able to go from a market where there is only once per month data and no buyers to a deep liquid market? We provided loan-level transparency on an observable event-based basis in the context of the security to all market participants.Each market participant was able to use the analytic and pricing model of their choice to independently value the collateral.Each market participant was then able to compare this value to the price the security was offered at to make a buy/hold/sell decision.

All investors understand that transparency is the cornerstone of deep, liquid markets. It removes the opacity that scares investors.As you just experienced, loan-level transparency restores trust, confidence and the willingness to invest capital in the credit markets.And it does it RIGHT NOW.

In our example, the value of maintaining liquid markets by providing observable event based reporting is $35 dollars (the $45 dollar price with observable event based reporting minus the $10 price traders, who are essentially bidding blindly, will offer when there is once per month or less frequent information.

What went wrong with the implementation of structured finance before today?It was implemented worldwide without loan-level transparency on an observable event-based basis.It had the veneer of liquidity but without the loan-level transparency infrastructure to support it.Therefore, it lacked the foundation for being a deep, liquid market.As we have just demonstrated, going forward, loan-level transparency on an observable event-based basis must be a basic feature of all structured finance deals since it makes it possible to monitor, value and trade these securities.

Please let us know if you think loan-level disclosure should be event-based or once-per-month.

Unfortunately, because the industry does not have loan-level data reporting on an observable event-based basis yet, you still do not know what is inside the brown paper bag right now. We, because we receive loan-level data on an observable event-based basis like Wall Street, do know what is inside the brown paper bag right now.

If you would like to make us an offer on the contents of the brown paper bag sight unseen, please e-mail your offer. We will then either accept or reject your offer.

If you are a current or former Master of the Universe or successful analyst, we multiply the difference between your offer and the value of the contents in the brown paper bag by $1 million. If we accept your offer and the contents of the brown paper bag are worth more than your offer, we will send you the check for the difference times $1 million. If we accept your offer and the contents of the brown paper bag are worth less than your offer, you will send us a check for the difference times $1 million. For everyone else, the difference is multiplied by $1,000.

Finally, we do not accept offers on the first business day of the month. These offers just confirm our belief in the importance of having the most current information which is exactly what loan-level data on an observable event-based basis is.

While we strongly prefer a market where the information is updated whenever an observable event involving the underlying collateral occurs so that we can check the assumptions in our models, we respect that there are far better analysts than us who do not like to check their assumptions that often. While we prefer to know exactly what has happened to the collateral, we respect that there are analysts who prefer to use once-per-month or less frequent data in their models and estimate what has happened to the collateral instead.

We are always looking for any competitive investment advantage we can get. Having a background that includes what Bloomberg called day trading, we are quite pleased to always have the 30+ day head start fresh data on an observable event-based basis gives us in pricing securities and calling market turns over the analysts who look at the stale accumulation of daily data once-per-month.

We happen to think that the idea of guessing what can easily be known is a sign of that dreaded, incurable affliction called "Analyst Conceit". Once contracted, analysts become susceptible to the delusion that even though they cannot value the contents of one brown paper bag they believe they can value the contents of many brown paper bags stuffed into one enormous brown paper bag.

What we do not have any respect for though are analysts who believe that using monthly data is right for everyone. If loan-level data on an observable event-based basis is made available, theneach analyst is given the choice of the frequency with which they look at the data.

We think that analysts representing investors in the riskier, lower rated portions of the deal will want to look whenever an observable event occurs and should not be denied this capability particularly if denying them information on an observable event-based basis reduces their investment appetite. We think this is critical because without these investors for the riskiest portions of the deal, there is not a structured finance market.

In addition, we think that analysts representing investors in the less risky, higher rated portions of the deal might not look as often. However, when they do, they will want the ability to look at the current status of every loan. This can can only be provided through observable event-based basis reporting.

Besides its contribution to restarting the structured finance market, we also believe that by using loan-level data on an observable event-based basis it is much easier to identify non-performing loans and immediately enforce our rights under the transaction's representations and warranties.

Finally, given that the cost of providing loan-level data on an observable event-based basis or once-per-month basis is built into the deal and effectively paid for by the buy-side, why is the sell-side and an isolated columnist fighting so hard to preserve once-per-month reporting?

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We would like to thank the visitors to our site who took the time to email us and express their support for paper (once-per-month loan level disclosure) or plastic (loan-level disclosure on an observable event-based basis). Like the McKinsey study, there is a heavy bias in the emails we have received in favor of greater disclosure or, in this case, loan-level disclosure on an observable event-based basis. Apparently, there is a bias towards knowing what is being purchased rather than buying the contents of a brown paper bag sight unseen. We are proud to be the drummer boys for loan-level disclosure on an observable event-based basis because we have a significant number of global market participants including investors and regulators marching to our beat.